Small shift in auditing priorities could have big tax gap effect, says GAO

A slight shift in Internal Revenue Service auditing resources from lower- to higher-income tax returns could have a big effect on recovering lost revenue, says the Government Accountability Office.

For a report (.pdf) dated Dec. 5 not released until Jan. 4, auditors simulated the effects of shifting about $124 million in enforcement resources into audits of individuals and businesses with taxable incomes of $200,000 or more. The result, they calculate, would be an additional $1 billion in tax revenue otherwise not collected. The latest IRS net estimate of annually lost revenue – what the tax agency calls the tax gap – is $385 billion annually.

The simulated move would mostly increase the frequency of correspondence exams – audits that don't involve face-to-face meetings and that target specific, limited scope issues. Correspondence exams yield on average $7 for every $1 spent whereas field audits generate only $1.8 per $1 on average, auditors say.

Auditors say they were careful not to propose too radical a reallocation of auditing resources so as not to cause extreme coverage rates, whether high or low, in any one tax return category. Large scale changes also can't be made quickly, since examiners require training, they note. The $124 million simulated change is less than 8 percent of the $1.6 billion the IRS spent on examining individual returns for the 2-year period covered by the simulation.

The simulation does rest on the assumption that the ratio of audit cost to revenue collected would remain stable, auditors acknowledge, but they point out that little is currently known about the value of audits on marginal cases. But because case selection includes some cases selected randomly, auditors say there is reason to doubt that exam cases lower on the list of IRS priorities always have lower value than those worked earlier.

Changing the allocating of auditing resources can also have direct and indirect effects on revenue collection, since generally the more a populace fears being audited, the more likely potential scofflaws among them are to be truthful at tax time. Auditors say their hypothetical reallocation would cause examination coverage rates to decline only modestly in lower-income areas, and that they believe that the gains in direct revenue made by reallocation would outweigh any negative losses caused by the smaller indirect effect of audits.